Refreshing note of caution injected into backdrop of investor complacecy

NoneMidland Reporter-Telegram

Published 10:00 am, Tuesday, January 18, 2011

The New Year has picked up right where December left off. The Santa Claus rally concluded with a respectable 1 percent gain for both the Dow Jones Industrial Average (DJIA) and S&P 500. Another widely watched seasonal pattern, the January early warning system, the performance of the New Year's first five days, was also positive (S&P 500 +1.1 percent and DJIA +0.8 percent). Historically, this indicator has had a very high accuracy ratio for the performance for the entire year.

In the past 38 "up" first five days of January for the S&P 500, an up year followed on 33 of those occasions. The average gain for all 38 years was 14 percent. With that kind of performance, it seems we can all just pack it in, set our portfolios on cruise control and go home for the year! To quote a popular football analyst: "Not so fast, my friends."

Last week ended with a modest gain for the averages and the sixth straight week of advances. The stock market, however, travelled a rocky, up and down road to get there. There were some disappointments along the way. The much anticipated December jobs report was met with mixed interpretations and sluggish stock performance last Friday. Nonfarm payrolls fell short of expectations by 50,000 jobs while the jobless rate fell more than expected because of statistical quirks.

The biggest disappointment to investor psychology, in our opinion, was that market participants were anticipating a better than expected figure in the December nonfarm payrolls report following Wednesday's ADP Employment report, which showed 297,000 new private sector jobs versus expectations of 100,000. But it didn't happen. Mixed interpretations played out in stocks because the October and November figures were revised up by a combined 74,000 jobs. Fed Chairman Bernanke weighed in on the same day and had a slightly more positive assessment of the U.S. economy, saying that "a self-sustaining recovery in consumer and business spending may be taking hold" but it could take four to five years for the labor market to normalize.

There have been a few more pundits in recent days warning of extreme valuations and advising defensive steps to protect profits in front of an imminent stock market correction. While these predictions may prove to be correct, the most important implication from our standpoint is that this is a refreshing note of caution coming against the backdrop of a high level of investor complacency at this time. With the absence of any meaningful pullback in stocks dating back to August, the bullish percentage in investor sentiment surveys (Investor's Intelligence, AAII) remains historically high and has barely budged from these elevated levels in recent weeks.

It is no secret then that given the market's current short term extended condition, it is vulnerable to normal pullbacks at any time. Our work in progress scenario is that there is further near term upside momentum that could carry all the way through January. We would then expect some type of pullback in the 4 percent to 6 percent range. The strongest two factors for this scenario to play out will be continued inline to better economic data and no major disappointments in fourth quarter earnings season, which kicks off this week.

More importantly, history has taught us that extended stock markets seemingly in need of a correction can persist much longer than most rational individuals would expect. This is the market's way of confusing the majority and why following the crowd is frequently wrong. For now, we are listening to the market's message of continued strong momentum, investor's desire to buy any dips in prices, and the Fed providing ample liquidity to support markets.

Past Performance is no guarantee of future results. Portions of this article were produced on January 11, 2010 by Scott Marcouiller, Wells Fargo Advisors Chief Market Strategist. Wells Fargo Advisors did not assist in the preparation of this article, and its accuracy and completeness are not guaranteed. The opinions expressed in the report are those of the authors and are not necessarily those of Well Fargo or its affiliates. The material has been prepared or is distributed solely for informational purposes and is not a solicitation or an offer to buy any security or instrumental to participate in any trading strategy. Additional information is available upon request (432)684-7335. Wells Fargo Advisors LLC., member SIPC is a registered broker dealer and a separate non-bank affiliate of Wells Fargo & Company. Investments in securities and insurance products are: NOT FDIC-Insured NO Bank Guarantee MAY Lose Value